Debt Inequality and Crisis Steve Keen Kingston University

Debt, Inequality and Crisis Steve Keen Kingston University London IDEAeconomics Minsky Open Source System Dynamics www. debtdeflation. com/blogs

When the economic history of our epoch is written… • There will be at least 3 themes: – Period of apparently increasing tranquillity (“Great Moderation”) – Sudden transition crisis (“Great Recession”) – Rising inequality • There should be (at least) a 4 th: – Rising private debt • Because all three go together and explain each other • Mainstream (Neoclassical) macro omits both inequality & debt • According to its indicators – Period of stable growth a permanent improvement in economy – Private debt macroeconomically irrelevant – Inequality simply a product of relative productivity • No longer maintained post-Piketty – But explanation limited to “r>g” • Statistical rather than causal explanation – “Great Moderation” a sign of policy success…

Mystery confluence: Great Moderation & Recession • “the past two decades has seen not only significant improvements in economic growth and productivity but also a marked reduction in economic volatility… dubbed ‘the Great Moderation’. ” (Bernanke 2004) I nflat io n & Une m p loym ent F alling Unemp lo yme n t Then “without warning” ion Deflat

Mystery confluence: Great Moderation & Recession • Post-crisis, see Moderation & Recession as 2 separate phenomena – 1 st due to good economic policy, 2 nd to exogenous shock… • “Standard macroeconomic models, such as the workhorse new. Keynesian model, did not predict the crisis, nor did they incorporate very easily the effects of financial instability. • Do these failures of standard macroeconomic models mean that they are irrelevant or at least significantly flawed? • I think the answer is a qualified no. Economic models are useful only in the context for which they are designed. Most of the time, including during recessions, serious financial instability is not an issue. • The standard models were designed for these non-crisis periods, and they have proven quite useful in that context. • Notably, they were part of the intellectual framework that helped deliver low inflation and macroeconomic stability in most industrial countries during the two decades that began in the mid-1980 s. ” – Bernanke 2010 “Implications of the Financial Crisis for Economics” • What utter, self-serving, bollocks!

Behaviorism vs Structuralism • Neoclassical DSGE models failed to anticipate crisis • Models use “behavior of rational agents” as basis of modeling – Since “Lucas Critique”, have asserted must capture “deep parameters” of individual behaviour for model to be valid • Post Keynesians have used “structure of economy” as basis – “Behaviour under fundamental uncertainty” considered – But behavioural concepts secondary to economic structure • My work combines this tradition with complex systems approach – Essence of complex systems: “simple system, complex behavior” – Sophisticated agent behaviour unnecessary to capture essential features of last 30 years of macroeconomics that Neoclassical models completely missed • Period of apparent diminishing cycles in employment & inflation • Rising private debt • Rising inequality as wages share falls, bankers’ share rises • Eventual crisis

Simple rules, complex behaviour • My 1995 Minsky model can be stated as strict identities: • The employment rate will rise if economic growth exceeds the sum of growth in labor productivity and population growth; • The wages share of output will rise if wage demands exceed the growth in labor productivity; and • The private debt to GDP ratio will rise if private debt growth exceeds the rate of economic growth – In equations:

Simple rules, complex behaviour • Equations are simply expansions of definitions • When put into simplest possible model – Generates both “Great Moderation” & Great Recession – Rising private debt – Rising inequality • Simplest possible model: – Output YR a linear function of capital KR – Investment IR a linear function of profit rate pr & depreciation – Employment a linear function of output – Wage change a linear function of employment rate – Change in debt equal to investment minus profits – No government sector, no Ponzi Finance, no bankruptcy

Simple rules, complex behaviour • Generates deceptively simple model: • 3 variables • 9 parameters (including r) • But complex behaviour… • Equilibria not the same as variables – Variables employment rate, debt ratio, wages share of output – Equilibria employment rate, debt ratio, profit share of output • Wages share a residual directly negatively related to debt service share (r. d) – Workers pay for rising debt via lower income share – Even without borrowing by workers in the model…

Simple rules, complex behaviour • “Good” equilibrium is: • Lower growth means higher equilibrium debt level • And makes equilibrium more unstable • Two possible outcomes depending on parameter values – Equilibrium stable • Cyclical convergence to positive employment rate, profit share, finite debt ratio over time…

Simple rules, complex behaviour • Not what we have experienced in the real world

Simple rules, complex behaviour • Equilibrium unstable: rising debt, rising inequality, moderation then breakdown: • Similar to what we have experienced in the real world… Falling then rising cycles io t a t R b e D e t a iv r P ng i s i R y l l lica c y C

Simple rules, complex behaviour • Model follows Pomeau-Manneville “inverse-tangent route to chaos” • First seen in transition from laminar to turbulent flow in fluids • Modeled as Poincare Map in y-coordinate of Lorenz system where system bounces between a curve and a line: • Dynamics of system determined by whether line intersects curve • For intersection – No fluid turbulence – Economic stability • For non-intersection – Turbulence – Instability preceded by diminishing cycles

Simple rules, complex behaviour • • Dynamics of system determined by whether line intersects curve If it does, stable equilibrium; cycles diminish to zero If it doesn’t, Unstable equilibrium • Cycles diminish at first and then increase • “Great Moderation” followed by “Great Recession” • Not 2 separate events but two stages in the same process…

Simple rules, complex behaviour • Weakness of model: even-handed nature of crisis—booms & busts • Real world experience: apparent moderation then bust only • Generated by generalizing earlier identities to include inflation: – The employment rate will rise if real economic growth exceeds the sum of population growth and growth in labor productivity; – The wages share of output will rise if money wage demands exceed the sum of inflation and growth in labor productivity; and – The private debt to GDP ratio will rise if the rate of growth of private debt exceeds the sum of inflation plus the rate of economic growth. • Additional equations needed for – Rate of inflation – Variable nominal interest rate – Simplest relationships used again: • Lagged convergence to equilibrium prices in monetary economy • Lagged inflation premium to base interest rate if inflation > 0

Simple rules, complex behaviour • Inflation formula derived from monetary flow logic • Depends on wages share of output & firms’ markup… Inflation-adjusted nominal interest rate 1 st order time lag determines inflation Inflation affects wages share Inflation affects debt growth Lagged interest rate reaction to inflation

Simple rules, complex behaviour • 4 D model, so formal stability analysis much more challenging • Empirical appears to yield fundamental instability. Linear functions…

Simple rules, complex behaviour • Nonlinear functions: • Without recent financial crisis, model could be dismissed as “just a mathematical curiousity” • But real world actually followed pattern in this stylized, simple model • Apparent period of tranquillity “Great Moderation” • Then sudden crisis “Great Recession”…

Simple rules, complex behaviour • Income distribution dynamics of model: – Profit share cycles around equilibrium level (before collapse) • Declining workers share offsets rising bankers share – Falling workers’ share signals approaching crisis (& causes deflation) Equilibrium profit rate Average profit below equilibriu m with nonlinear behaviour

“no significant macro-economic effects” • Simple non-equilibrium, nonlinear model with simple behavioural modelling captures what mainstream failed to anticipate • Why did mainstream economists ignore debt (& not see crisis coming)? • Conventional macro: private debt is macroeconomically irrelevant: – “The idea of debt-deflation goes back to Irving Fisher (1933). – Fisher envisioned a dynamic process in which falling asset and commodity prices created pressure on nominal debtors, forcing them into distress sales of assets, which in turn led to further price declines and financial difficulties… – Fisher's idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). • Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, • pure redistributions should have no significant macro-economic effects…” (Bernanke 2000, Essays on the Great Depression, p. 24)

Bernanke’s view versus reality • In the data… • In my simulation of Minsky… • Crisis only inexplicable if you ignore “ 3 rd dimension” of private debt • Private debt conspicuously absent from mainstream macro…

What is the mainstream missing? • Role of banking sector in creating new money, demand income – “banking is where left and right meet. – Both Austrians … and Minskyites view banks as institutions that are somehow outside the rules that apply to the rest of the economy, as having unique powers for good and/or evil… – I guess I don't see it that way. – Banks don't create demand out of thin air any more than anyone does by choosing to spend more; and banks are just one channel linking lenders to borrowers…” (Krugman, “Banking Mysticism”) • Essence of opposition is “Loanable Funds” model of debt: – “Think of it this way: when debt is rising, it’s not the economy as a whole borrowing more money. – It is, rather, a case of less patient people—people who for whatever reason want to spend sooner rather than later—borrowing from more patient people. ” (Krugman 2012, End this Depression Now! , p 147) • IF this model described reality, THEN debt would indeed not matter…

Analyzing this with system dynamic modelling • Most Neoclassical models ignore banks, debt and money • Those that do treat banks as “mere intermediaries” that arrange loans between savers and borrowers • Banks themselves don’t lend in Neoclassical models • E. g. , Eggertsson & Krugman 2012: – Patient Consumer agent lends to impatient Investment agent • Investment agent pays interest to consumer agent • Bank charges “intermediation fee” for arranging loan – Both hire workers – Buy output from each other – Sell to workers & bank – Investing agent changes borrowing and repayment rates – Does debt matter? No…

The conventional “Loanable Funds” vision of lending • Full model: Bank arranges loan from Consumer sector (Patient) to investment (Impatient) sector & charges intermediation fee • Workers hired, output produced & sold, investment… Bank Balance Sheet FlowsStocks Initial Conditions Lending Debt Repayment Interest Payments Bank Fee Hire Workers (C) Hire Workers (I) Purchases (C) Workers Consumption Bankers Investment Assets Reserves 100 ID -20 -Lend Repay int WI IC -CI -IB Liabilities CD -60 Lend -Repay -int Fee WC -IC CI -CW -CB WD -15 -WC -WI CW • Debt doesn’t appear here: Asset of Consumer Sector… Equity BE -5 -Fee CB IB

The conventional “Loanable Funds” vision of lending • Consumer Sector “Godley Table” Assets Equity FlowsStocks CD D CNW Initial Conditions 60 10 -70 Lending -Lend Debt Repayment Repay -Repay Interest Payments int -int Bank Fee -Fee Hire Workers (C) -WC WC Bankers Consumption CB -CB Purchases (I) CI -CI Workers Consumption CW -CW Purchases (C) -IC IC • Lending reduces Consumer Sector’s Asset of Cash at the Bank • Increases Consumer Sector’s Asset of Loan to Investment Sector • Consumer Sector’s does without Cash for duration of Loan

The conventional “Loanable Funds” vision of lending • Simulated, Krugman/Bernanke correct: debt doesn’t matter… • But a radical thought: what if—just maybe—banks lend money? ? ?

Varying lending & repayment in Endogenous Money • Changing debt matters: change in money supply causes change in GDP • Logic behind this: aggregate demand & income include change in debt

Loanable Funds, aggregate demand & income • • Consider 3 sector model with sectors S 1, S 2, S 3 Expenditure not debt-financed shown by CAPITAL LETTERS Debt financed expenditure shown by lowercase letters 3 situations considered – Borrowing not possible – Borrowing from other sectors possible (“Loanable Funds”) – Borrowing from banks possible (“Endogenous Money”) • First case “Say’s Law” (actually “demand creates its own supply”) Activity Expenditure (Exp. ) Sector 1 -(A + B) Sector 2 C Sector 3 E Net Income Sector 2 Sector 3 A B -(C+D) D F -(E+F) • Negative sum of diagonal elements is aggregate demand • Sum of off-diagonal elements is aggregate income

Loanable Funds, aggregate demand & income • Clearly Expenditure Income: • Loanable Funds: Sector 1 borrows b from Sector 2 to spend on Sector 3 – Sector 1’s funds for spending increase by b – Sector 2’s funds fall by b (split 50: 50 between S 1 & S 3 for simplicity) Activity Expenditure (Exp. ) Net Income Sector 1 Sector 2 Sector 3 Sector 1 -(A + B+b) A B+b Sector 2 C-b/2 -(C+D-b) D-b/2 Sector 3 E F -(E+F) • Aggregate outcome clearly the same as without borrowing • But what if a bank lends to Sector 1? – Assets & liabilities of banking sector rise equally; and… – Increased spending power for Sector 1 not offset by fall in Sector 2

Endogenous money, aggregate demand & income • Rise in Sector 1’s spending, and incomes of Sectors 2 & 3 Activity Expenditure Net Income Sector 1 Sector 2 Sector 3 Sector 1 -(A + B+b) A B+b Sector 2 C -(C+D) D Sector 3 E F -(E+F) • Aggregate outcome greater (if b>0) than without borrowing • Increase in debt causes equivalent increase in expenditure and income – Aggregate demand income are • Demand¦Income from turnover of existing money; • Plus Demand¦Income from newly created money • Generalises to flow of new lending (d. D/dt: change in debt per year) • Consider flow of expenditure from existing money stocks S 1…S 3 plus expenditure from flow of new debt-created money d. D/dt…

Endogenous money, aggregate demand & income • S 1 to S 3 now represent deposit account of relevant sector • Rate of spending per year by SA on SB shown as v. AB • Bank equity account BE added to record interest payments… Bank Accounts Turnover of existing money New Gross finance Debt • I. e. , Both aggregate expenditure and aggregate income are – Non-debt financed Expenditure (i. e. turnover of existing money) – Plus the change in debt (creation of new money & demand-income) – Plus gross financial transactions

Endogenous money, aggregate demand & income • Leads to dynamic, non-equilibrium, endogenous money Monetarism versus Friedman’s static, equilibrium, exogenous (“Helicopter Money”) Quantity Theory • Static Friedman: • Dynamic monetary: • Change in GDP: Gross New Debt financial Debt change & acceleration • So a monetary vision of capitalism is essential – (with finance since most debt money created for asset purchases) • Private debt a huge “omitted variable error” in mainstream economics – This is why they didn’t see the crisis coming – Not because unpredictable – But because their models exclude the forces that caused the crisis: • Rate of change and acceleration of private debt…

US Aggregate debt levels • Ignoring private debt has led us into biggest debt trap in history… Level when I began to warn of crisis (2006) Level when Godley began to warn of crisis (1998)

Global aggregate debt levels • Trend to excessive private debt common across the globe

Dramatic fall in credit growth post-crisis

Credit growth dictates economic growth

Whole world has “turned Japanese”

Debt dynamics dominate asset markets • According to Modigliani-Miller, these should be uncorrelated… Correlation 0. 96 (unexpected)

Debt dynamics dominate asset markets • According to Modigliani-Miller, these should be uncorrelated… Correlation 0. 69 (unexpected)

Debt dynamics dominate asset markets • According to Modigliani-Miller, these should be uncorrelated… Correlation 0. 53 (expected)

Debt dynamics dominate asset markets • According to Modigliani-Miller, these should be uncorrelated… Correlation 0. 77

Turning Japanese • Japan’s past 18 years gives us best case scenario projection for OECD…

Dramatic fall in credit growth post-crisis • Decades of anaemic credit growth lie ahead… China credit growth now collapsing…

The China Crisis • China has done in 6 years what took 17 in USA & Japan:

The China Crisis • China undergoing 2 nd stock market crash, but first with high leverage Margin debt 0. 000014% of GDP Margin debt >2% of GDP

The China Crisis • Acceleration of margin debt key driver/indicator of market Correlation 0. 69 since 2014; 0. 87 since 2015

Solution? Modern Debt Jubilee • Only effective solution to debt-deflation is private debt reduction – Could be done by “Quantitative Easing for the People” • CB direct injections into private bank accounts • Those in debt must cancel debt • Those not in debt get cash injection • Rebase money system to more fiat, less credit-based money • Restructure banking to – Reduce appeal of Ponzi lending (mortgages, margin loans) • “PILL”: Property Income Limited Leverage • Maximum loan factor (say 10 times) estimated income of property being bought – Meld venture capital with banking • “EEL”: Entrepreneurial Equity Loans • Banks get equity stake in loans to entrepreneurs • Alternative is continuous stagnation—as with Japan since 1990 • Main barrier? Misplaced moral perception of debt

Solution? Modern Debt Jubilee • Moral responsibility of debtor product of interpersonal view of debt • Person to person loan—lender has to do without what he lends Bank Balance Sheet FlowsStocks Initial Conditions Lending Debt Repayment Interest Payments Assets Reserves 100 ID -20 -Lend Repay int Liabilities CD -60 Lend -Repay -int WD -15 Equity BE -5 • But bank loans are creation of money & debt “out of nothing” Bank Balance Sheet Assets FlowsStocks Reserves Loans Initial Conditions 100 Lending Lend Debt Repayment -Repay Interest Payments ID -20 -Lend Repay int Liabilities CD -60 WD -15 Equity BE -5 -int • Bank doesn’t lose pre-existing money if loan not repaid • Instead bank over-produced money & debt—should write them off

Solution? Modern Debt Jubilee • Stop falsely thinking of banks as warehouses (“Loanable Fund” view) • Start thinking of them as “money factories” – Can over-produce money and debt – Write-off of excess production should be routine – Especially since recent production socially counterproductive • Asset bubbles caused by leverage – Mortgage acceleration drives house price change – Margin acceleration drives share price change • Effectively funding Ponzi Schemes…

Conclusion • Theoretical: getting structure of economy (including finance) right more important than accurately modelling agent behaviour • Revised realistic view of banking essential to understand where the crisis came from & work out how to escape it • Monetary complex systems macro needed in theory and policy • Practical: current situation inevitably will give rise to political conflict – Modern politics dominated not by Eisenhower’s “military-industrial complex” but Minsky’s “politico-financial complex” – Conventional “Ordo-Liberal” response to crisis (as in Greece) compounds basic weaknesses of capitalism • Modern Debt Jubilee needed to save capitalism from its own dynamics Kingston University London